Fundraising 101, Part 1: When and Whether to Raise
First - a personal update. Today we announced the $4M seed round for my new company. We put together an in-depth document about the new company and the fundraise here.
With this post, I’m trying something new. This is part 1 of a 2-part series focused on fundraising advice. Please let me know what you think of this style :)
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Funding. Everyone wants it, but most fail to get it.
This is easily the most understood subject in the startup world—at Udemy, we made every mistake in the book. I’m writing this guide because in 2009, it would’ve saved me a lot of grief.
The most important thing about fundraising is realizing that 95% of the time, you are wrong about what you need, why you need it, and when you need it. (To be clear, when I talk about “fundraising,” I’m talking about raising risk capital from investors funding tech companies).
If you’re only interested in advice about HOW to fundraise and not WHETHER to fundraise, you’ll probably fail. That’s why Part 1 of this series is about Whether and When, and Part 2 is about How.
A few rules of thumb
You should fundraise when:
If you succeed, an angel investor could make a 100x+ return on their money. That’s 10,000%!
You’re ready to commit 5-10 years to this business and are willing to walk away with nothing, even if the business is profitable and “successful.”
You are willing to have a boss. Once you have investors, you have a boss. So if you started this company to have freedom, don’t raise money.
You want to share in the outcome. If you raise money, you will likely raise more money, which means you will likely eventually have less than 25% of the company. If you have co-founders, you could have less than 5%. Today, the founders of Udemy all have very low ownership %.
You should NOT fundraise when:
You need money. Nobody cares about your needs. How often do you buy things just because the seller NEEDS the money? Very rarely, and usually only with throwaway capital. So don’t expect investors to give you money because you need it.
You would be happy with a $1M outcome to yourself. If $1M sounds like a lot to you, just bootstrap. You are much more likely to get $1M that way.
Your business is not hyper-scalable. Angel investors are looking for businesses that can grow to $100M in 10 years or less. If your business is going to take longer to reach that milestone, you probably shouldn’t raise money.
To better understand this, let’s look at what’s at stake on both sides of this deal. I like to think about it in terms of two halves of the story: (1) How investors look at you, and (2) How you look at investors.
(1) How investors see your startup
Investors need 100x. Angel investing is a risky game. Startup companies have lots of ways to fail - the market doesn’t materialize, the technology doesn’t end up living up to the promise, the founders have a messy breakup, etc. We have historical numbers on this, and we know that only a small % of seed-funded companies return money to investors. Based on the historical math, investors know that they must make ~100x their capital to make money. That’s because only 1 in 25 or 1 in 50 of their investments will make money. When they do, that investment has to make back the remainder of the money they lost on the other companies.
Put another way, if I have 25 investments on 25 companies that are each at $50,000, that’s $1.25M I’ve invested. Odds are, only one of them will succeed. So, I need that company to return at least $1.25M for my money back! But I don’t just want my money back: I need a return that beats the stock market. Also, I don’t get my money back right away; I get it back 8-12 years after I invest. So, I need roughly 3x my money back on this investment for it to be better than stock market returns. My $50,000 investment in that winning company has to turn into $4M or 80x my initial investment.
I know it sounds crazy, but we have five decades of angel investing data to look to, and that’s why we know these numbers. This means you must understand how your business can get to at least 80x the initial investment. If you don’t, you probably shouldn’t raise money.
Investors care about timing. You might be building a great company, but that doesn’t mean it’s the right time for investors to fund you. At Udemy, we went out to raise for the first time in August 2009. We didn’t end up raising anything until August 2010—a year later. We wasted hundreds of hours of blood, sweat and tears trying to raise money simply because we were raising at the wrong time!
If you’re a first-time founder, you almost certainly need to have a product in the market and have customers actively using the product. Either that, or you have a few extremely good references at venture-backed startups who can vouch for you and are willing to be active advisors or (ideally) small-check angels.
If you can’t get a product to market without money, investors won’t believe you will do that much better with money. They have thousands of companies pitching them every day and many of them have thousands of dollars in revenue or tens of thousands of users.
Investors care about scale. This means it’s really important for you to understand scale.
You need two major things here:
A big market opportunity
A solution that can grow fast
Markets are hard to define, and I won’t explain it in full here. To get a 100x return on a $25,000 investment, you probably need to get to $100M in revenue (or $1-5B in valuation). So, you’re looking for a market big enough for that kind of company. Ideally, there are already dozens of companies in your space (or in similar spaces) that are way bigger than that!
In terms of speed of growth, the key here is to understand you have to grow to $100M in revenue in 10 years. Do the math. Roughly, if you grow at 4% per week or 20% per month to start, you are on the right track. 99% of businesses can’t grow that fast, but 99% of businesses are not fit for angel investments.
(2) How I recommend seeing investors
Investors aren’t the key to success. The biggest mistake entrepreneurs make is they think they need money to succeed. Oftentimes, this is just a crutch—an illusory requirement that makes it easy for you to feel good, instead of actually doing good.
Many entrepreneurs make the mistake of thinking “Oh, if only I had X, then I’d be successful,” when actually X is wrong. If X to you is investors, you’re wrong. It’s not investment that makes you successful; it’s customers. If you get customers and no investment, you can build a successful business. And if you get customers, you are more likely to get investment. But there are tens of thousands of startups with money that never end up getting customers and therefore do not succeed.
Taking money from investors means committing to a path. This is important. When you raise money, you commit to following a specific path. Angel investors expect you to try to build a multi-billion dollar company. That is the implicit agreement in most angel investments from credible investors.
This means you must use the money to grow as fast as possible. Usually, if you‘re trying to grow fast, that means you are spending more money than you’re making. There will also be other companies trying to compete with you: almost every good startup idea in history has been tried by many founding teams. To keep up with this competition and the expected growth rate, the average startup spends money in cycles of 18 to 24 months. Every 18-24 months, you will run out of money, and you’ll need to raise more and more capital.
Each time you raise capital, you’ll likely sell 10-40% of your business. After 2-4 rounds, investors will control more of the company then you do and will become your boss. In fact, they are your boss even from day 1, because if they’re unhappy, they can make it difficult for you not to raise follow-on rounds.
Furthermore, it often takes up to 5 years to even realize if your idea is any good. I spent 4 years on Sprig, raised $60M and eventually shut it down! I took a very low salary (about ½ or ¼ what the market would pay me) and eventually ended up with nothing.
There are many paths to success
Many people don’t realize that usually, you can actually achieve your goals by starting a regular business, rather than a venture-backed startup. If you start a business, you don’t have investors (or maybe you have a small amount of money invested from friends and family), and you don’t owe them a 100x return. Instead, you can simply build the business to profitability and then take money out of the company every year.
If you do a great job here, you can even build it to a multi-million dollar company and make millions of dollars for yourself! I have at least a dozen friends who have done this to great effect. So, weigh your options carefully: there are many paths to success, and raising venture capital isn’t always the best one.
If you’ve read this and you’re planning to fundraise, “Part 2: How to Raise” is coming soon! Sign up below to get it when it’s ready.
